US Equities Enduring a Pullback, Not a Crash

Given the health of the ClearBridge Dashboard, we believe U.S. equity market turmoil will be relatively short-lived. That should render this period a pullback rather than a market crash.

It can be hard to pinpoint the level at which equities find a bottom. It is important to view non-recessionary pullbacks through three dimensions: price, time and sentiment. While several sentiment surveys have ticked down recently, they remain at broadly elevated levels.

Overall, we may be close to an inflection point. A great deal of negative news is priced into the market. This should allow for positive surprises relative to expectations.

One casualty of the recent market volatility has been price-to-earnings (P/E) multiples. The combination of a strong earnings environment and negative returns brought valuations down considerably. In fact, 2018 witnessed the third greatest annual decline in P/E levels over the past four decades, even greater than the P/E compression experienced in 2008.

Today's environment is similar to several periods when market weakness and substantial P/E compression occurred against a backdrop of economic and earnings strength. Historically, these periods have been followed by solid stock rebounds.

The market multiple is near five-year lows, a level consistent with the last two major growth scares. P/E contraction has been concentrated in cyclical sectors, which are overly discounting the chances of a recession in 2019. The backdrop shares several attributes with 1984 and 1994: a strong economy, robust earnings growth, substantial P/E compression and a weak stock market.

In 1984, earnings growth was 21%, real GDP roughly 7%, P/E multiples contracted by two turns, and the market finished up 2%. Similarly, in 1994, earnings growth was 19%, real GDP was 4%, P/E multiples came in three turns and the market fell 1.5%. Following these years of lowered expectations and derating, the market bounced back: a 26% return in 1985, a 35% gain in 1995. Key to these rebounds was a lack of recession in the year following the resetting of expectations.

Several risks remain for stocks, including trade tensions, slowing earnings growth and potential policy errors by the U.S. Federal Reserve. Tariffs likely will remain in the headlines as negotiations continue between the U.S. and China.

Ultimately these risks will be bricks in the wall of worry that the market climbs higher in 2019. The healthy fundamental backdrop — combined with attractive equity valuations, a possible Fed pause and more Chinese stimulus — all point toward a rebound, rather than a prolonged crash.

Jeffrey Schulze, CFA, is an Investment Strategist at ClearBridge Investments, a subsidiary of Legg Mason. His opinions are not meant to be viewed as investment advice or a solicitation for investment.